Interest rate essay
Causes ofcan be explained as -deferred consumption. When money is loaned the lender delays spending the money on consumption goods. Since according to time preference theory people prefer goods now to goods later, in a free market there will be a positive interest rate. Inflationary expectations. Most economies generally exhibit inflation, meaning a given amount of money buys fewer goods in the future than it will now. The borrower needs to compensate the lender for this. Alternative investments. The lender has a choice between using his money in different investments. If he chooses one, he forgoes the returns from all the others. Different investments effectively compete for funds. Risks of investment. There is always a risk that the borrower will default on the loan. This means that a lender generally charges a risk premium to ensure that, across his investments, he is compensated for those that fail. Liquidity preference. People prefer to have their resources available in a form that can immediately be exchanged, rather than a form that takes time or money to realize. Taxes. Because some of the gains from interest may be subject to taxes, the lender may insist on a higher rate to make up for this loss.
The nominal interest rate is the amount, in money terms, of interest payable. The real interest rate, which measures the purchasing power of interest receipts, is calculated by adjusting the nominal rate charged to take inflation into account. There is a market for investments which ultimately includes the money market, bond market, and stock market and currency market as well as retail financial institutions. The CAPM returns the asset-appropriate required return or discount rate – i.e. the rate at which future cash flows produced by the asset should be discounted given that asset’s relative riskiness. Betas exceeding one signify more than average “riskiness”; betas below one indicate lower than average. Thus a more risky stock will have a higher beta and will be discounted at a higher rate; less sensitive stocks will have lower betas and be discounted at a lower rate. The CAPM is consistent with intuition – investors (should) require a higher return for holding a more risky asset.
Since beta reflects asset-specific sensitivity to non-diversifiable, i.e. market risk, the market as a whole, by definition, has a beta of one. Stock market indices are frequently used as local proxies for the market – and in that case (by definition) have a beta of one. An investor in a large, diversified portfolio (such as a mutual fund) therefore expects performance in line with the market.
The risk of a portfolio is comprised of systematic risk and specific risk. Systematic risk refers to the risk common to all securities – i.e. market risk. Specific risk is the risk associated with individual assets. Specific risk can be diversified away (specific risks “average out”); systematic risk (within one market) cannot. Depending on the market, a portfolio of approximately 15 (or more) well selected shares might be sufficiently diversified to leave the portfolio exposed to systematic risk only.
A rational investor should not take on any diversifiable risk, as only non-diversifiable risks are rewarded. Therefore, the required return on an asset, that is, the return that compensates for risk taken, must be linked to its riskiness in a portfolio context – i.e. its contribution to overall portfolio riskiness – as opposed to its “stand alone riskiness.” In the CAPM context, portfolio risk is represented by higher variance i.e. less predictability.
Exactly how these markets function is a complex question. However, economists generally agree that the interest rates yielded by any investment take into account:
?The risk-free cost of capital
?Inflationary expectations
?The level of risk in the investment
?The costs of the transaction
The risk-free cost of capital is the real interest on a risk-free loan. While no loan is ever entirely risk-free, bills issued by major nations like the United States are generally regarded as risk-free benchmarks.
This rate incorporates the deferred consumption and alternative investments elements of interest.
The CAPM says that the expected return of a security or a portfolio equals the rate on a risk-free security plus a risk premium. If this expected return does not meet or beat the required return, then the investment should not be undertaken. The security market line plots the results of the CAPM for all different risks (betas).
All investors are risk averse because,
?There are no arbitrage opportunities.
?Returns are distributed normally.
?Fixed quantity of assets.
?Perfect capital markets.
?Separation of financial and production sectors.
?Risk-free rates exist with limitless borrowing capacity and universal access.
The CAPM returns the asset-appropriate required return or discount rate – i.e. the rate at which future cash flows produced by the asset should be discounted given that asset’s relative riskiness. Betas exceeding one signify more than average “riskiness”; betas below one indicate lower than average. Thus a more risky stock will have a higher beta and will be discounted at a higher rate; less sensitive stocks will have lower betas and be discounted at a lower rate. The CAPM is consistent with intuition – investors (should) require a higher return for holding a more risky asset.
The risk of a portfolio is comprised of systematic risk and specific risk. Systematic risk refers to the risk common to all securities – i.e. market risk. Specific risk is the risk associated with individual assets. Specific risk can be diversified away (specific risks “average out”); systematic risk (within one market) cannot.
A rational investor should not take on any diversifiable risk, as only non-diversifiable risks are rewarded. Therefore, the required return on an asset, that is, the return that compensates for risk taken, must be linked to its riskiness in a portfolio context – i.e. its contribution to overall portfolio riskiness – as opposed to its “stand alone riskiness.” In the CAPM context, portfolio risk is represented by higher variance i.e. less predictability.
The model does not appear to adequately explain the variation in stock returns. The model assumes that investors demand higher returns in exchange for higher risk. It does not allow for investors who will accept lower returns for higher risk. Casino gamblers clearly pay for risk, and it is possible that some stock traders will pay for risk as well. The model assumes that all investors agree about the risk and expected return of all assets. The model assumes that there are no taxes or transaction costs, although this assumption may be relaxed with more complicated versions of the model. The model assumes that asset returns are log-normally distributed random variables. There is significant evidence that equity and other markets are complex, chaotic systems. As a result, large swings (3 to 6 standard deviations from the mean) occur in the market more frequently than the normal distribution assumption would expect. These swings can greatly impact an asset’s value. The market portfolio consists of all assets in all markets, where each asset is weighted by its market capitalization. This assumes no preference between markets and assets for individual investors, and that investors choose assets solely as a function of their risk-return profile. It also assumes that all assets are infinitely divisible as to the amount which may be held or transacted. The market portfolio should in theory include all types of assets that are held by anyone as an investment (including works of art, real estate, human capital…) in practice, such a market portfolio is unobservable and people usually substitute a stock index as a proxy for the true market portfolio. Unfortunately, it has been shown that this substitution is not innocuous and can lead to false inferences as to the validity of the CAPM, and it has been said that due to the in-observables of the true market portfolio, the CAPM might not be empirically testable.
The efficient market hypothesis (EMH) asserts that financial markets are “efficient? or those prices on traded assets, e.g. stocks, bonds, or property, already reflect all known information and therefore are unbiased in the sense that they reflect the collective beliefs of all investors about future prospects. The efficient market hypothesis implies that it is not possible to consistently outperform the market ? appropriately adjusted for risk ? by using any information that the market already knows, except through luck or obtaining and trading on inside information. Information or news in the EMH is defined as anything that may affect stock prices that is unknowable in the present and thus appears randomly in the future. This random information will be the cause of future stock price changes.
It is a common misconception that EMH requires that investors behave rationally. This is not in fact the case. EMH allows that when faced with new information, some investors may overreact and some may under-react. All that is required by the EMH is that investors’ reactions be random enough that the net effect on market prices cannot be reliably exploited to make an abnormal profit. Under EMH, the market may, in fact, behave irrationally for a long period of time. Crashes, bubbles and depressions are all consistent with efficient market hypothesis, so long as this irrational behavior is not predictable or exploitable.
Or in other terms, an ‘efficient’ market is defined as a market where there are large numbers of rational, profit-maximizers actively competing, with each trying to predict future market values of individual securities, and where important current information is almost freely available to all participants. In an efficient market, competition among the many intelligent participants leads to a situation where, at any point in time, actual prices of individual securities already reflect the effects of information based both on events that have already occurred and on events which, as of now, the market expects to take place in the future. In other words, in an efficient market at any point in time the actual price of a security will be a good estimate of its fundamental value. There are three forms of the efficient market hypothesis
1.The “Weak” form asserts that all past market prices and data are fully reflected in securities prices. In other words, technical analysis is of no use.
2.The “Semi-strong” form asserts that all publicly available information is fully reflected in securities prices. In other words, fundamental analysis is of no use.
3.The “Strong” form asserts that all information is fully reflected in securities prices. In other words, even insider information is of no use.
Securities markets are flooded with thousands of intelligent, well-paid, and well-educated investors seeking under and over-valued securities to buy and sell. The more participants and the faster the dissemination of information, the more efficient a market should be.
